Preparing for the RINO Fall-out

After a series of events with almost comical dimensions, we now have the first case of fraud on the Nasdaq, involving a Chinese small cap company. RINO International (RINO) admitted Friday that it did not enter into two contracts for which it reported revenue during its 2008 and 2009 fiscal years. The stock has been halted by the NASDAQ Stock Market around noon on November 17, and it will remain halted until RINO has fully satisfied NASDAQ's request for additional information. NASDAQ has not specified what kind of information they are looking for, but at this time it seems unlikely that RINO will be allowed to remain listed on the prestigious NASDAQ market. Investors should be prepared to find the stock on the pink sheets in a couple of weeks.

Earlier on Friday, the first official statement in the RINO case came from its auditors, Frazer Frost LLP, in form of a letter issued in an 8-K Filing with the SEC.

In a telephone conversation on November 16, 2010, Mr. Zou Dejun, the Chief Executive Officer of the Company, informed Ms. Susan Woo of our firm, in substance, that as to the six RINO customer contracts discussed in the recent report of Muddy Waters LLC, the Company did not in fact enter into two of the six purported contracts, and a third contract among the six was explainable. When Ms. Woo inquired about the Company's other contracts, Mr. Zou said he was not sure, but there might be problems with 20 - 40% of them. Assuming that these statements were reasonably accurate, it appears that our reports would have been affected if this information had been known to us at the date of our reports, although the effect on the financial statements is currently unknown and cannot be quantified without a thorough investigation. We further note that in a conversation the following day, November 17, 2010, involving Ms. Woo, several directors of the Company, Company counsel, and Mr. Zou, Mr. Zou stated that he was not sure the day before and went back to look into some things, and found that apart from the two problematic contracts, all other contracts are legitimate and can be verified.

The language used in this letter gives those very serious events an almost comical note. The CEO said "he was not sure" and "there might be problems," then "went back to look into some things." And Frazer Frost is "assuming that these statements were reasonably accurate" to conclude that "it appears that" their audited reports were wrong as they might have based their findings on forged invoices.

The very basic conclusion from last week's events is that RINO is not taking their status as an U.S.-listed public company any bit seriously, and that Frazer Frost did a pretty lousy job as an auditor. To fall for forged information of such a magnitude raises the question of what exactly Frazer Frost did attempt to verify, if anything at all. This will likely lead to lasting damage for the reputation and credibility of Frazer Frost and the market has already started to punish other clients of the firm.

In Friday's trading Frazer Frost clients were among the biggest losers. China Valves Technology (CVVT) dropped 15.28% for the day to close at $8.93, snubbing off any upside from a Roth Capital upgrade ($16 price target) before the open. Harbin Electric (HRBN) closed at $16.95, down 10.7%, and the stock finds itself now 30% below the $24 going-private offer it received a couple of weeks ago. Other FF clients affected were Fushi Copperweld (FSIN, down 6.69%), China Fire & Security (CFSG, down 5.86%) and China Medicine (CHME, down 4.20%).

Another stock that is directly affected is Orient Paper (ONP, down 7.00% on Friday). Rino International's fall is the first big success for 2-man (short-selling) research firm Muddy Waters LLP who released a very detailed report about the company on November 10, which led to the reported series of events. Muddy Waters' previous target was Orient Paper, but that company has very determinedly defended itself and its stock price had stabilized recently. With the collapse of RINO the focus might now shift back to ONP and put the stock under renewed selling pressure until the results of the ongoing independent investigation into MW's allegations is presented.

So what will happen next? Will this lead to new or resumed short-selling attacks on a variety of Chinese small caps? Most certainly it will! Short sellers have the whole weekend and beyond to come up with pretty much anything, knowing that whatever they get published will likely have an immediate effect on the stock price, as with the RINO disaster they now have a precedent of Chinese fraud on the Nasdaq. Those companies do already have a hard time defending themselves, even against totally ridiculous allegations. And always keep in mind that not all those attacks will be unfounded, it is very likely that RINO is not the only Chinese company with severe irregularities in its financial statements. But don't make the mistake to interpret this as a "China problem," other than that Chinese companies are just the easiest targets right now.

Will we see a new downtrend for the sector similar to what we all have experienced last summer? That depends on the direction of the general markets in the U.S. and China. It is an undeniable fact that big money is very eager to put their money in (perceived) quality Chinese companies, proven by the China IPO craze of the last three months when most offerings opened for trading some 30-50% above their IPO price. However, if we see the general appetite for risk fading, or the S&P 500 heading for a 10-15% correction, I would expect China small caps to lose value twice as fast. Right now I am still bullish for equities in general, but less so than two or three weeks ago. We should be prepared for both scenarios now.

This RINO situation is serious. Even the biggest bulls will now have a hard time dodging smear attacks on perfectly healthy stocks from China which just happen to have some detail in common with RINO, being it company structure, a sub-par public accounting firm, a weak Board of Directors, or the way they became a public company. It might be that the normal "innocent until proven guilty" is turned upside down for the time being, especially for those companies that do not take their U.S.-listed public company status seriously.

What we should do is looking at business models and trying to understand them. Doing our own in-depth research and see if we can be comfortable with what we find out. Looking at management credibility and perceived credibility. Who is running the company, which investors are backing it? Personally I am no longer willing to risk my money with a $250MM stock that chose to reaffirm Kabani or similar as their auditors, nor am I seeing the point in holding a position in a stock that doesn't even bother to do earnings calls. Talking about big board names here only, for Bulletin Board stocks and companies that are early on their way of maturing he have to set different requirements. However even there, companies that choose not to communicate at all should be treated with extreme caution.

This is not the time to run away from China stocks. Smart money will always look for value, and you have to find out where the value is, what companies you want to invest in, and why exactly you would do that. Re-evaluate your holdings, make adjustments now, and prepare yourself for possible "bargain hunting" with quality stocks that might get beaten down in the RINO aftermath, but don't deserve to be treated in the same way for reasons you have to determine for yourself.

I am making several adjustments to the China Model Portfolio today:

Changda International (CIHD) is currently trading at $0.75, down 76.20% for the year and down 69.76% from its April 5 high at $2.48. The Trading China Tracker Score is 20 (Strong Buy).

Changda has posted strong third quarter numbers last week, however an equity raise is still looming. CIHD has not reached our price target of $1.00 yet, however we are locking in profits here to protect our gains in the light of the RINO situation. We are closing the position here for a gain of 78.57% or $3,927.

Gulf Resources (GFRE) is currently trading at $10.53, down 9.70% for the year and down 12.25% from its April 15 high at $12.00. The Trading China Tracker Score is 13 (Strong Buy).

While I have little doubts about the integrity of Gulf Resources, the stock has been a target before, also mentioned along RINO in the infamous Barron's "Beware..." article. I believe it is prudent to secure profits here as this is one of the stocks that might see a short-selling attack. We are closing the position here for a gain of 61.75% or $3,087.

Renhuang Pharmaceuticals (CBP) is currently trading at $2.41, up 145.91% for the year and down 19.67% from its April 9 high at $3.00. The Trading China Tracker Score is 16 (Strong Buy).

Renhuang is close enough to our price target now, so we can take profits here as well. We are closing the position here for a gain of 67.36% or $3,367.

Wonder Auto Technology (WATG) is currently trading at $8.50, down 27.60% for the year and down 33.44% from its April 9 high at $12.77. The Trading China Tracker Score is 5 (Hold).


Wonder Auto disappointed us with their third quarter report. Account receivables more than doubled for the quarter and the stock still couldn't get above a "Hold" rating on the China Tracker. I would also expect the company to upgrade to a Big4 auditor as soon as possible. We are closing the position here for a loss of 3.30% or $164.

ZST Digital Networks (ZSTN) is currently trading at $7.25, down 17.24% for the year and down 14.51% from its November 8 high at $8.48. The Trading China Tracker Score is 10 (Buy).

We are also selling our ZSTN position here. The only reason is that we are not entirely comfortable with the company's business model, there are open questions about the reported margins and future prospects (GPS) which lead us to believe that ZSTN does not pass our high quality standard for senior exchange stocks at this time. We are closing the position here for a gain of 29.46% or $1,471.